Iran Faces a Decision

 | Jan 12, 2012 | 5:00 PM EST
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As Iran continues its uranium-enrichment program, it increasingly alienates the rest of the world, not just the U.S. and Israel. Economic sanctions are having a real effect on the Iranian economy, which is still growing. But the prospect of an international agreement to embargo Iranian oil is imminent.

Annual national aggregate inflation is increasing toward 25%, but the costs of consumer goods and basic necessities are running much higher and beginning to cause mounting social stress. As a result, the Iranian government is getting pressure from inside and outside the country.

What the world is waiting for is how Iran will respond as the economic sanctions are increased. Iran is also waiting to see which, if any, countries violate the embargo and continue to do business with them.

The biggest buyer of Iranian oil is China. The second is Japan. So far, China is hesitant to go along with an embargo because it needs the oil. Japan, however, announced today its intention to participate in the embargo. Russia is lending its support begrudgingly, too. So there is a lot of pressure on China to participate.

The $64,000 question is how Iran responds or reacts to the pressure. There are only two fundamental choices: acquiesce to international pressure or fight it.

If Iran shutters its uranium-enrichment program, it could embolden the citizens -- perceiving weakness in the government and military -- to pursue an Arab Spring revolution.

Prior to the overthrow of the Shah, Mohammad Reza Pahlavi, in 1979, Iran was the most westernized country in the region. The vast majority of the Iranian citizens prefer a return to something similar, with a secular government.

Such a situation may cause minor disruption in oil supply, but it's not something that will cause economic or market disruption to the extent that investors can prepare for.

The issue investors need to be wary of is if Iran fights instead. The government leadership, aware of the potential for an Arab Spring if they capitulate to international pressure, may feel compelled to challenge international pressure and an embargo through military means.

How they do it is less important to investors than if they do it. In this situation, oil prices would rise rapidly, with the ultimate price determined by whether or not China participates in the embargo. This would cause price inflation to increase immediately, and for U.S. economic activity to plunge.

That's what happened in 1973 during the oil embargo: oil prices increased immediately by 100% and then by 400% in less than a year. The U.S. economy stagnated and the stock market crashed. The simultaneous increase in costs and decline in economic activity gave rise to the term "stagflation." It's not a perfect comparison, but it is a good starting point for investors to ponder.

Even if China does not participate, an increase to the $200-per-barrel range within a month or two is reasonable to anticipate. Because of the U.S. strategic reserves, a system put in place following the Arab oil embargo, there should be little or no disruption in real supply. Gasoline prices, however, would double.

Rising oil prices would push up shares of Exxon Mobil (XOM), BP (BP) and Chevron (CVX), but the indices overall would decline rapidly as an increase in energy prices would suck capital from the productive economy.

Between 1973 and 1975, gold prices rose from $44 to $180 an ounce before falling back to $100 an ounce by 1977. Gold had just become eligible for public trading in 1973, so I would be cautious making comparisons to either that run or the 1975-1977 correction. If you must choose between them, the 1975-1977 term is more akin to the current environment, so be careful. (The run from $100 to $800 between 1977 and 1980 is another matter altogether and should not be considered here.)

Treasury-note yields and mortgage rates were little changed during the 1973 oil crisis. In the current environment, a flight to safety should be anticipated, which will drive the long-end yields even lower.

For the time being, I would not take any action until Iran decides which way to go. But be mindful that Iran will have to decide soon, and international pressure will continue to increase until then.

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